Inside Financial Services

More Capital Won’t Solve the Problem

Recent bank-reform proposals are beside the point. Inadequate liquidity is the problem, not capital.

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In order that the financial system avoid another meltdown, Senators Brown and Vitter want the big banks to operate at a 15% capital ratio. The editorial writers at Bloomberg have decided is should be more like 20%. Anat Admati, the new patron saint of the bash-the-big-banks crowd, thinks it should be as high as 30%. Do I hear 40%?

Bank skeptics seem to have gotten the notion into their heads that if only banks’ capital levels were high enough, the risk of a replay of the 2008 crisis would effectively fall to zero, and all would be well with the world. Baloney. At the depths of a financial panic, it’s not inadequate capital that usually dooms banks, it’s inadequate liquidity. If you doubt it, let’s play a mind game. Let’s pretend it’s September 2008 again, you’re in charge of overnight lending at a large financial institution, and the fellow from Lehman Brothers is on the phone. The Bloomberg editors’ wishes have preemptively come true and Lehman’s equity ratio is a plump 20%. Would you provide Lehman with another day’s worth of funding?

Spare me the bravado; no, you would not. Why? Because in those panic-pitched days, no one had any idea what Lehman Brothers’ underlying assets were worth and, to be on safe side, people chose to assume the worst. Sixty cents on the dollar? Fifty cents? The basement was the limit! The losses implied by those numbers would have swamped even the mightiest balance sheet. More important, even if you thought you had a handle on the matter (which you did not), you weren’t sure Lehman’s other lenders did, so that in the worst case, you’d provide the overnight funding while the others held back, and Lehman would blow up anyway, only with your money and nobody else’s. Smart career move! Thanks anyway, but you’d pass.

Moral of story: in the midst of a panic as severe as the one the would-reformers are seeking to prevent, no amount of capital is enough to douse the fears of nervous lenders. Should banks hold adequate capital? Of course they should. But there’s a limit to what’s sensible and economic, and we’re already long past that point. Since the panic has passed, banks have been forced to bolster their balance sheets to such a degree that, at most institutions, the optimal use of the marginal dollar of capital is to simply return it to shareholders via dividends or buybacks. Adequate investment returns simply aren’t there to be had.

Nosebleed levels of capital don’t solve the problem. Rather, ensuring adequate liquidity is a much more crucial safeguard of solvency. As far as that goes, liquidity risk has been much reduced with the promulgation of Basel III.

In the meantime, this notion that boosting capital requirements would have no macroeconomic effect (“Such a requirement wouldn’t harm economies,” as Bloomberg blithely puts it) is idiotic on its face. In a note to clients Monday, my pal Dick Bove points out that, to achieve the capital levels Bloomberg has in mind, the banking industry would have to add $1.26 trillion in equity. It could either raise the $1.26 trillion via equity offerings (and good luck with that), shrink assets by $6.3 trillion, or do some combination of the two. Given the equity raises banks have already had to do in recent years, banks would mostly shrink. If you think the banking industry can collectively deleverage by $6 trillion without crimping the creation of credit, you really do need to be in a different business.

I have news for the people who are seeking to reform the banking industry: no matter what bright ideas you come up with, you’re not going to remove all the risk from lending. (And if you do, the business will be worthless.) And as long as there is risk, there’s the risk of bank failure. What’s needed aren’t schemes that would prevent failure under any circumstance (those won’t work), but rather a practicable plan to handle failures of any size that would treat creditors fairly and keep taxpayers out of the picture.

In the meantime, the best risk protection is the one that’s the most time-tested and, ironically, the one the reformers resist: diversification. It is no accident that the big banks that came through the crisis the best, JPMorgan Chase and Wells Fargo, are the ones that didn’t go crazy on mortgage lending and have a broad range of income streams, from asset management, to market-making, to, yes, mortgage lending. When the mortgage business went down in flames, the other businesses were there to pick up the slack. Yet now reformers propose that banks shed many non-core business and become more dependent on lending than ever. How this is supposed to make the system safer and more stable is beyond me.

There are ways to take some of the risk out of the financial system. Congress might, for example, repeal that cussed Volcker Rule. Unfortunately, the ideas being thrown around that are getting the most attention would likely make the system less safe, rather than more so, and would slow economic growth, to boot. That’s not my idea of a helpful solution. Senators Brown and Vitter, Professor Admati, and the writers at Bloomberg have got things all wrong.

What do you think? Let me know!

9 Responses to “More Capital Won’t Solve the Problem”

  1. jsc173

    Tom, all good points. Perhaps the most persuasive point is that all these proposals are non-starters. Investment capital has no interest in banking and hasn’t been interested for years. Only when “Wall Street” sees the ability to leverage capital into high returns will they be interested in raising capital for their banking clients.

  2. Mjamesson

    Tom,

    I believe you are missing the point to having capital. When there is a panic in the market, no private lender is going to extend credit to anyone that doesn’t have good collateral. This is why the Fed ultimately is the lender of last resort. The crisis, panic (pick your own word) was a combination of too much leverage (Lehman over 30 times) and short-term funding of illiquid assets. With a 15% capital ratio, there is likely to be a much larger cushion of good collateral that the Fed can lend against. Some limit on short-term funding may also be needed, but it makes sense to begin somewhere with something simple that is not subject to gaming by the industry.

  3. bob atwell

    I seldom disagree with Tom’s perspective, but this time I do. The “liquidity” crisis was born of bad assets backed by insufficent capital.

    Mandating higher capital standards would end the Too Big to Fail problem. Investors are not interested in capitalizing bubble factories to the 20% level. For this reason Tom need not fear that materially higher capital ratios will be implemented. Leveraged TBTF institutions are not naturally occuring “free market” creations, rather a necessary instrument of federal economic policy. Raising capital standards would stop the nonsense, but would cause economic contraction. The impact on deficits would obliterate the myth of federal economic omnipotence. At the heart of this crisis is cherished fantasy that financial shenanigans create real economic value. This is what the death of Keynesianism looks like.

  4. bob atwell

    I seldom disagree with Tom’s perspective, but this time I do. The “liquidity” crisis was born of bad assets backed by insufficent capital.

    Mandating higher capital standards would end the Too Big to Fail problem. Investors are not interested in capitalizing bubble factories to the 20% level. For this reason Tom need not fear that materially higher capital ratios will be implemented. Leveraged TBTF institutions are not naturally occuring “free market” creations, rather a necessary instrument of federal economic policy. Raising capital standards would stop the nonsense, but would cause economic contraction. The impact on deficits would obliterate the myth of federal economic omnipotence. At the heart of this crisis is cherished fantasy that financial shenanigans create real economic value. This is what the death of Keynesianism looks like.

  5. Bill

    How about a proposal to boost big banks’ dividends? I’m sitting on thousands of JPM shares and I feel like I’m getting donkey punched by the Fed every quarter I get a check.

  6. DSB

    Tom, you are correct as is the old banking adage, “They don’t go bankrupt, they just run out of cash”. Liquidity is the lifeblood in a crisis and Bagehot’s words on the topic were raised more than a few times during the financial crisis. However, your use of Lehman Brothers as an example is illustrative of the way forward, but maybe not in the way you intended. Lehman Brothers was a second rate investment bank, they were justifiably under attack by Einhorn, they had a brand new CFO who was out of her league at a critical moment in time, they were cooking the books, had an opaque balance sheet and they were levered way more than 30 to 1. Oh, and they were led by a dick (not referring to Mr. Fuld’s name) who had alienated staff, industry participants and the people who could help save the firm. So yes when the call came for liquidity, in any environment, you would have had to be pretty dumb to put your career on the line for Lehman.

    So if we look at the companies that almost brought down the financial system they were Bear Stearns, Lehman, Merrill Lynch and AIG. See a pattern? Investment banks were mostly allowed to self regulate themselves, were levered to the sky (Deutsche Bank USA negative $8.8 billion of equity) and had plenty of off balance sheet exposures. AIG – well can you call that regulation? By contrast when WaMu and Wachovia went down there was barely a ripple in the continuum. In fact you ended up with a fight over which bank got to acquire Wachovia.

    Yes Brown-Vitter and the Volcker rule are less than optimal for various reasons, but they are attempts to deal with the underlying problem, though not directly. The underlying problem of which I write is the great travesty which was the repeal of Glass-Steagall in response to the threat from Sandy Weill. Let banks be commercial/retail banks. Set clear capital rules without risk weightings, don’t adopt Basel III and the notion that sovereign debt is safe liquidity and allow for sane regulation. The regul

  7. Pat O'Brien

    “… wouldn’t harm economies.” – Where does Bloomberg find these people? I have to go to the LA Times to find more idiotic suggestions than I have read on Bloomberg.

    Banks with retail (guaranteed) funding had little to no trouble with their liabilities in the crisis. Wholesale funded banks did. That’s what drove Wachovia into the arms of Wells Fargo, they had a full blown run on their wholesale liabilities in the second, third and furth quarters of 2008. If all banks were funded 100% with equity, we’d never have a run. I wonder what the unemployment rate would be in that environment? Either lots of lending (and economic activity) would be eliminated as unprofitable or the price of money would have to rise to a point to incent banks to lend. Today a good bank earns maybe 100bp on assets and 12% on equity. If ROA and ROE were equal, what would the price of a loan be?

  8. JRG

    Increased capital requirements are the best way to reduce high risk behavior and one effective way to break up the top six banks which needs to happen. Except for WFC these banks want to engage in short term high risk activity to boost quarterly earnings. A great example is the JPM blowup in London. The reality is that investing in consumer and small business banking takes time and committment and at the end of the day does not have great returns. This is the fundamental problem with banking – its not a growth busines. Attempts to make it so have resulted in the continual stream of banking crisises wehave seen over the 30 years. Diversification does not prevent blow ups. Citi, BofA, were diversified in 2007.

  9. Ron

    I think that you overlooked the probability that having the higher capital standards would have avoided the panic in the first place. The economy would not have gotten as wound up as it did; thus, no unwinding (or a less severe one) would have taken place.

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